Investing: Are junk bonds ready to fall?

Feb. 7, 2013
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Financial data / Thinkstock

by John Waggoner, USA TODAY

by John Waggoner, USA TODAY

If you rely on investment income to pay your bills, you have two choices. You can invest in ultra-safe, interest-bearing investments, such as bank CDs and money funds, and share a burrow with a kindly gopher. Or you can take some extra risk.

For most people, the answer has been "take more risk." And for many people, the investment of choice has been junk-bond funds, which the mutual fund industry demurely calls "high-yield funds." The question now is just how high that is. The answer: Not much now, but it will grow in the next two years.

If anyone has a beef with the Federal Reserve, it's savers. The Fed has kept short-term interest rates near zero since 2008. As a consequence, the average money market mutual fund yields 0.02%, or 20 cents a year per $1,000, according to iMoneyNet.

To get more interest, you'll have to tie your money up for a longer period of time. You could, for example, invest in a five-year Treasury note. If you hold your note to maturity, the government will pay you a princely 0.83% a year, or $8.30 per $1,000. Woo.

To reach 5% to 6%, you'll have to take credit risk, which refers to the possibility of not getting all your money back. Suppose, for example, you decided to buy a long-term IOU from Swell Computer, a struggling computer manufacturer. Swell Computer bonds will pay 7% a year for 10 years, after which they return your principal.

The deal sounds good, but essentially you're wagering that Swell Computer will still be swell a decade from now, during which time your cat will have a more powerful computer than the one you're using now. Should Swell go bankrupt, you'll have to stand in line with the rest of Swell's creditors, hoping to get some of the proceeds from the sale of their office furniture.

And this is what a junk bond is: A loan to a borrower who may not be able to make timely principal and interest payments. Because the junk-bond issuer has shaky credit, he has to pay a higher interest rate. The average junk-bond fund had a 6.1% yield last year, according to Lipper.

Because savings rates are so low, investors have been pouring money into high-yield bond funds - an estimated $32 billion last year, says Lipper. And those investors were rewarded: The average junk fund gained 14.7% last year, assuming reinvested income.

Much of that return came from investors bidding up the prices of junk bonds. As the economy improved, the odds of shaky companies returning to solid footing looked better. That's good.

What's less good, from an investor's point of view, is that bond yields fall as prices rise. Junk yields are now below 6% for the first time in history. The question now: Have investors loved junk bonds too much, and are they ready to fall?

At the moment, probably not, says Mark Durbiano, who has skippered Federated High-Income Bond since 1987. "Credit quality is very strong on a historical basis, and defaults rates are low."

The default rate for high-yield bonds was 3.2% in December, says John Lonski, chief economist for Moody's Investor Service. He expects it to fall to about 2.8% by June. In contrast, the default rate in October and November 2009 was a dizzying 14.6% - the worst since the Great Depression.

Assuming the economy chugs along slowly, junk investors can expect to earn decent interest, but not the capital gains they have seen in recent years. "It would be a reasonable expectation to earn 6% to 7% over the course of the year," says Fran Rodilosso, manager of Market Vectors Emerging Markets High Yield Bond ETF.

Nevertheless, this is an area where junk investors need to be wary. For one thing, new issues are starting to flood the market, and that's rarely a good sign for any market. "That gets your antenna up," Rodilosso says.

And you can only believe junk bonds are relatively low compared with Treasuries if you think the Federal Reserve will continue its program of buying mortgages to keep long-term rates down. "If you think the 10-year Treasury note should be 4.5%, then high yield is not so cheap," says David Sherman, manager of RiverPark Short-term High Yield fund.

With short-term interest rates so low, investors have few choices that don't involve taking on more risk. If you do decide to take more risk, you have to monitor your investments more carefully. In the case of high-yield bonds, you should look for funds with low expenses: After all, the more you give to your fund manager, the less you keep for yourself.

You can also reduce risk somewhat by looking at what types of bonds the fund buys. Higher-quality bonds that mature in a relatively short time tend to be less prone to big price dives than long-term bonds issued by the worst issuers. The RiverPark fund, for example, invests in extremely short-term bonds, and yielded about 3.9% last year.

In any event, keep your expectations low for junk bonds this year, and watch them carefully. In the last junk-bond meltdown, the average junk fund fell 30%, according to Morningstar - and that's including reinvested interest. So don't put all your income investments into junk, unless you really want to live with the gophers.